Let’s take a look at a recent bond trade to discover how I adjusted a put fly gone awry. Throughout the winter wilting in equities, bond prices were booming amid a classic flight to safety trade. As is often the case when fear seizes the Street, stocks become oversold and bonds overbought.

On December 11th, I reasoned TLT was sufficiently stretched to justify deploying an out-of-the-money put fly. The position started out delta negative and theta positive. Take a look at the charts below and see if you agree with my forecast of a pause or pullback for the stock:

The initial trade was a $3-wide January put fly purchased for 74 cents. With TLT trading at $119, I bought the Jan $113 and Jan $119 puts while selling two of the Jan $116 puts. Said another way, I bought the Jan 113/116/119 put butterfly. The ideal scenario was for TLT to drift lower toward $116 and for a few weeks of time to pass.

Here’s the risk graph of the original trade:

Though TLT did pause as predicted, it only did so for a day or two before ripping higher to $122. The rally carried TLT well outside of my profit zone thus requiring a large selloff to return the position to a profit. Using the risk graph above, look at how far away $122 is from my breakeven. Rather than sitting tight I entered a second fly – the Jan 116/119/122 for a 92 cent debit. The adjustment had two primary benefits.

First: I shifted my upper breakeven point from $118.25 to $120.35. By widening the profit zone I modified the position to recoup its loss much quicker when TLT finally pulled back in price.

Second: I shifted the theta much higher thereby improving the delta/theta ratio. The new position had more exposure to time decay relative to the amount of directional risk I had.

Here is how adding the second fly improved my risk graph:

After making the adjustment, I settled in to wait for some type of pullback toward $120 and below. We finally got it this week. With the long-awaited snap-back finally arriving for stocks, the fear bid in bonds dissipated. TLT has retreated from $122 to $120 and should continue to fall if the stock rebound can persist for another few days.

At $120, TLT has returned to my profit zone, and my losses have been all but recovered. By keeping a cool head and not panicking when bonds went from overbought to overbought(er), I was able to make a logical adjustment that improved my probability of profit. Furthermore, this case study illustrates the power of scaling-in. By pre-planning the potential entry of a second or third fly, I was able to give myself multiple chances of nailing a top and eventual turnaround in bond prices.

The choice now is whether I want to exit swiftly at breakeven and move on or settle in to see if my original forecast starts to prove true.

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